The market is full of talk about the credit crisis, rampant consumer debt and major slowing in consumer spending. Banks are tightening the purse-strings and worldwide, loans are harder to come by while individual debt continues to snowball.

One thing the economists don’t often do is offer insight as to what rampant spending and consumer debt means to you and I at a personal level.  For some of you this may be basic accounting and money management, and if it is, I apologize.

But the sad truth is most of us, (some of us investors included), don’t take the time to calculate the long-term cost of carrying current consumer debt. So in an effort to open some eyes, I offer some simple analysis.

Let me preface this by saying: If you have already earned your millions, and money is not a concern, then spend away! This article is for the rest of us, who are still trying to build that nest-egg of financial independence.

This example demonstrates the power of compounding interest in our investing activities, and shows how consumer debt robs our investment portfolio of long-term wealth.

The Cost of Luxury

For this exercise, we'll calculate the long-term cost of maintaining a luxury car payment over a non-luxury model. A Toyota Camry SE (best-selling car in America), costs $21,240, according to Toyota.com. Assume you finance the full amount, at 7% for 60 months, your monthly payment is $421.

Now, the luxury version of the Camry, the Lexus IS (a gorgeous automobile), runs right at about $40,000 with mid-tier options. Financing that full amount, again at 7% for 60 months, boosts your monthly payment to $792.

So the difference in just the monthly payment of the Camry versus the Lexus is $371. Ignoring the fact that the Lexus is also much more expensive to insure, let’s do some analysis. Every year you spend an additional $371 per month, or $4,452 a year on that Lexus. 

We’ll assume that you always keep that Lexus payment, which statistically speaking is a near certainty for most consumers. Nobody ever “downgrades” their car as they get older. So each month indefinitely, you’re spending an additional $371 on a luxury car over a “regular” car. 

Over the course of the next 35 years, you would spend an extra $151,000 to have that luxury. That doesn’t seem so bad, does it?

Unfortunately, that’s only the first chapter of the whole story.

Compounding Interest and Investment Growth

Let’s now assume you can make a solid 10% annual return in your investing. Have you ever considered how much money that additional $371 per month would be worth if you had invested it in your brokerage account instead of upgrading your car? How much does that $371 a month compound to over 35 years?

Let’s do the math. You sell the Lexus in year one, and buy the Camry instead. In the second year, you would save $4,452 on payments, plus you would make an additional $445 on the investing return, for a total of $4,897.

Doesn’t seem like much, right?

The next year you save another $4,452, and add it to the $4,897 from the previous year, for a total of $9,349, which earns you 10% as in investment, adding another $934. Now your total is $10,284.

You start to see the speed of compounding. You can see an annualized breakdown below, but suffice it to say, in year 10, your growing pot of gold is over $62,000. In year 15, it’s $132,000. In year 20 it’s $246,000, and year 25 it’s grown to a respectable $428,000!

And by year 34, that amount has grown to over $1,000,000, just by investing the difference between a Camry and a Lexus, and just on the cost of the vehicle alone. Insurance and maintenance only compound the issue.

Is any car worth a million dollars?

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So maybe you don’t drive a Lexus. Maybe you already drive a Camry? Whatever you drive, or whatever your lifestyle, consider the debt you are carrying. If your car payment is currently only $375, consider the impact of dropping the payment altogether. The math is the same. In 35 years, that car has cost you over a million dollars.

Maybe it’s a boat, maybe a second home, maybe an addiction to $75 an ounce caviar. Whatever debt you may carry, consider what it’s costing you in the long run, and consider the wealth-building power in investing that money over the long haul. 

The other side to this story is the potential earning power you gain by becoming a successful investor. Let’s assume that you could earn 14% on your money by managing it yourself. You could have made more than $3 million by the end of the 35 year period, and hit the $1 million mark 7 years earlier.

Is it worth it to use discipline and educate yourself? Uh, yeah.

To learn more, read Compounding Interest and be sure to watch the video.

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3.25 Copyright (C) 2007 Alain Georgette / Copyright (C) 2006 Frantisek Hliva. All rights reserved."